Correction Likely to Continue on Weak Rebound; Spain Is Key

Since peaking earlier in the month the S&P 500 sold off less than 5% into last week’s lows while the markets have consolidated over that time. After last week’s correction we reached technical levels often associated with decent rallies and yet the weak rebound in the markets tends to suggest less enthusiasm from the bulls and likely indicates the correction isn’t over. There are a few potential catalysts out there that could move the markets in either direction so watching these key points of data may provide clues as to the market’s likely direction.

Weak Rebound Suggests Correction Continues

Dips in the McClellan Oscillator below -200 (red dashed line below) are often are associated with short and intermediate bottoms. However, after reaching these levels we usually see a strong thrust signal in the markets with strong breadth in which the McClellan Oscillator jumps north of +100. After last week’s dip below -200 in the McClellan Oscillator we couldn’t even breach neutral territory and so the McClellan Summation Index (BOTTOM PANEL) continues its downward march. I’m guessing at a minimum we retest last week’s lows or possibly head lower.

Source: Bloomberg

While I believe the markets continue to correct I believe this remains an intermediate-term correction rather than a bull market top. One of the reasons I believe this is that sector rotation often always occurs near major or significant tops in which the cyclical sectors of the economy weaken relative to the S&P 500 as these sectors begin to discount a coming peak in economic activity. Both the S&P 500 Consumer Discretionary and S&P 500 Financial Indexes peaked well before the S&P 500 did at the last bull market top in 2007. For example, the S&P 500 Financial Index peaked on May 23rd 2007 and the S&P 500 Consumer Discretionary Index peaked on June 4th 2007 while the S&P 500 peaked on October 11th 2007. Both of these two cyclical sectors gave ample warning of a coming bear market.

Source: Bloomberg

In 2011 we were given ample warning again by cyclical sector relative strength in which the S&P 500 Financials, Technology, and Consumer Discretionary sector’s relative strength peaked in February, months before the May 2nd peak. Also of note, all three sectors' relative strength bottomed before the S&P 500 did, with the Consumer Discretionary and Technology sectors providing the earliest warning.

Source: Bloomberg

Looking at these cyclical sectors' relative strength in 2012 shows no major deterioration prior to the April 2nd top. All three sectors were outperforming the market heading into this month and are giving no major warning signals as they did at the 2007 and 2011 tops. So, while the correction is likely to continue I believe it is in the context of a bullish long term trend rather than part of a major market top.

Source: Bloomberg

Headwinds, Tailwinds, and Unknowns

One of the likely reasons the S&P 500 has held up well since peaking earlier in the month is the earnings season. Of the 94 companies within the S&P 500 that have reported so far, 80 of them have beaten earnings expections for an 85% beat rate. This is the highest beat rate in over five years.

While U.S. corporate earnings have been stellar, the overall market remains weighed down by concerns over Europe, Spain in particular. The Spanish IBEX 35 stock index has retraced all of the advance off of the 2009 lows and is facing a key test. The IBEX is also testing the lower trend line of its bearish trend that has been in place since 2010 and so for it to head lower from here would mean two bullish supports would be broken and that the bearish trend that began in 2010 is accelerating. This would have very bearish implications for financial markets globally as it would indicate the credit crisis in Europe is erupting once more as the crisis which began at Europe’s periphery (PIGS) is moving more and more to the core.

Source: Bloomberg

While Europe has been and continues to be a global headwind, China, which had been a headwind since the middle of 2009, may become a tailwind as Chinese equities (bottom panel above) are likely discounting future easing by Chinese monetary authorities. The Shanghai Index bottomed on January 6th and put in a higher low on March 29th and has continued to rally despite weakness in Europe and the U.S. The strength in Chinese equities likely heralds a pickup in China’s economy which would be a bullish support for global growth in the second half of the year.

Given the above, China's support will remain muted as long as the situation in Europe continues to deteriorate. The credit default swaps (CDS) on Spanish and Italian 5-year sovereign debt continues to climb with Spanish CDS’s hitting new highs and Italy’s accelerating at a rapid clip. The deterioration in European sovereign debt markets is weighing on European banks which have given back all of their 2012 gains and continue to breakdown. For signs of stabilization we will need to see CDS for Spain and other European nations come down and European banks to rally. If they fail to do so, then financial stress in Europe will continue to build and weigh on global markets.

Source: Bloomberg

Summary

The markets have been in a corrective mode since peaking earlier in the month. While the S&P 500 has rallied a bit since last week’s lows the rebound has been incredibly weak and suggests lower prices are needed to bring back the bulls. Earnings season has been very strong with the highest beat rate in five years so far which is helping to offset the negative news out of Europe. Right now things in Europe are centered on Spain and the Spanish stock market rests at key support levels. A further breakdown in the Spanish IBEX 35 would likely indicate things in Europe are unraveling further and could spill over into global financial markets. How the IBEX performs in the coming week will likely be a key market tell for where financial markets are heading. The IBEX and the Shanghai Composite should be monitored ahead for key reads on Europe and China to see if these two regions remain headwinds or tailwinds.